PROS AND CONS OF FOREIGN BANKS

Entry of foreign bank brings both positive and negative effect on the host country. These are
called pros and cons of foreign bank. The pros include better resource allocation, higher
competition and efficiency, lower probability of financial crisis, enhanced public
confidence in the banking sector, enhanced access to international capital, and
development of the underlying bank supervisory and legal framework.
On the other hand, the cons of foreign bank penetration include loss of domestic banks’
market share, instability of the domestic deposit base, credit rationing to small
firms, loss of domestic banks’ profitability, foreign domination and control of the banking
system, volatility of domestic financial markets, and worsening of the domestic
financial system’s ability to respond to large internal and external shocks.

Pros of Foreign Bank Penetration

In the main, the reasons for relaxed restrictions on foreign bank participation in banking
systems all over the world are traceable to the pros (i.e. perceived benefits) of foreign bank
presence. Several authors have addressed the potential benefits of foreign bank entry for
the domestic economy in terms of better resource allocation and higher efficiency.
Foreign banks may
(i) Enhance a country’s access to international capital.
(ii) Serve to stimulate the development of the underlying bank supervisory and
legal framework.

(iii) Improve the quality and availability of financial services in the domestic
financial market by increasing bank competition, and enabling the application of more
modern banking skills and technology.

However, foreign banks have to be sizable for there to be any significant transfer
of banking technology to the domestic banking sector.
Foreign ownership of banks is often thought to improve overall bank soundness,
especially when the foreign parent banks belong to well-regulated financial systems
that are themselves healthy. Such parent banks are expected to provide greater access to
the capital and liquidity that bolster balance sheet strength, and to transfer to local
banks the skills and technology that enhance risk management and internal controls. More
broadly, foreign bank presence is expected to fortify emerging market financial systems
by encouraging higher standards in auditing, accounting and disclosure, credit risk
underwriting, and supervision.

Foreign banks improve the quality and availability of financial services in the domestic
financial market by increasing bank competition, and enabling the application of more
modern banking skills and technology. Thus, foreign bank entry has positive welfare
implications for all facets of customers of banking and other financial institutions.

Banking crises positively correlate with limitations on foreign bank entry into domestic
markets. Thus, merely reducing such limitations and easing the ability of foreign banks to
enter the domestic banking market reduces the incidence of banking crises, even if
foreign banks do not enter. In sum, findings suggest that potential entry of
foreign banks proves beneficial on the stability of the domestic banking market.

Regarding the link between foreign penetration and financial stability, other things
equal, the presence of foreign banks is associated with a lower probability of financial crisis. If
foreign-owned banks forestall liquidity shocks as a result of being better aided by their
highly capitalized parents, a country with an internationalized banking sector may be partially
isolated from bank runs, irrespectively of the risk-taking behaviour of their foreign-owned
institutions. In fact, the presence of foreign banks prevents a bank run in the first place.

It is also commonly believed that foreign-owned banks provide stability in times of

financial crises. Studies of the Argentina and Mexico crises indicate that in a credit crunch,
foreign-owned banks are able to provide credit growth that domestic banks are not
able to provide In a similar element, foreign banks may provide higher and more
sustained credit flows than their domestic counterparts. However, foreign banks only offer a
source of stability if their operations are less sensitive to host-market conditions than the
local banking firms.

It is also widely believed that the presence of foreign banks helps governments to
attract further foreign direct investment inflows. Supporters of foreign bank entry argue that these
banks provide an important channel for foreign capital inflows to finance domestic activities.
If these foreign funds complement rather than substitute for domestic sources of funds, then
a net expansion of available funds that supports higher economic growth reports specific
cases in Pakistan, Turkey, and Korea, where foreign banks helped to make foreign capital
accessible to fund domestic projects.

Foreign bank presence can promote improvements in government regulation and

supervision of the financial system due to the unfamiliar business practices that they import
into the host country. Domestic regulators would initially find these unfamiliar business
practices difficult to evaluate and supervise; however, as time unfolds, new systems and
laws would be created to deal with the new problems arising as a result of the fresh
lines of activities and problems within the financial system.
Cons of Foreign Bank Penetration

In the main, the reasons for tightening restrictions on foreign bank participation
in banking systems all over the world are traceable to the cons (i.e. perceived
demerits) of foreign bank presence. Rather unfortunately, several studies have revealed that
foreign bank participation has several negative consequences. Notable among them are
competitive pressures resulting in significant loss of domestic banks’ market share and
profitability instability of the domestic deposit base especially during times of systemic
crises, and the worsening of the domestic financial system’s ability to respond to large
internal and external shocks.
Competitive pressures arising as a result of foreign bank participation in a banking
system have negative consequences that are evident in various ways.

Firstly, competitive pressures arising as a result of foreign bank participation in a

banking system could result in significant loss of domestic banks’ market share with
various accompanied consequences. Gradually and increasingly, international banks have
been known to target multinational corporations, foreign agencies and international firms. In
doing so, they leverage off the international banking relationships of their parent banks
and home country contacts. Under such circumstances, indigenous banks have an
uphill task retaining or acquiring the accounts of these multinationals, foreign
companies and agencies.

Also, if foreign banks appear more stable than domestic institutions, they may attract the
“best” domestic borrowers (higher-profit and lower-risk borrowers), putting domestic banks in
the more precarious position of lending to less credit-worthy borrowers. In this case,
indigenous commercial banks are forced to give attention to micro and rural credits.

In a cross-country study, it was found that foreign bank entry leads to a decrease in
domestic bank profitability, banks’ non-interest income, and bank overall expenses, but
only when entry is measured by the share of foreign banks in the total number of banks
rather than their share in the assets of the banking system. Though domestic banks’
overhead costs are lower in countries with substantial foreign bank presence;
domestic banks’ pretax profitability in high foreign-entry markets is much lower than in
markets with low foreign bank presence. From an empirical analysis, also found that
increased penetration of foreign banks in the domestic banking system (as measured by
the relative importance of foreign banks in either the total number of banks, or total
assets, of the banking system) is associated with a reduction in both profitability and
overhead costs for domestic banks. However this indicates an improvement in domestic
bank efficiency.
Foreign bank entry has also been discovered to have a statistically positive impact on
the level of loan loss provisioning of domestic banks. This is because foreign bank
entry leaves domestic banks to cater for relatively less creditworthy customers, or
alternatively foreign bank entry triggers a strengthening of provisioning regulations affecting
all banks, thus leading to larger reported provisioning for bad debts by domestic banks

It has been argued that entry of foreign banks may not lead to enhanced stability of the
domestic banking system, because their presence per se does not make systemic banking
crises less likely to occur—as may happen if the economy undergoes a deep and
prolonged recession, leading to a massive increase in default rates and an across-the-
board increase in nonperforming loans, and because they may have a tendency to
“cut and run” during a crisis. Some observers have argued that the fact that foreign
banks may withdraw suddenly after a period of time if they fail to establish
profitable operations is also a potential drawback associated with foreign bank
entry. However, what is problematic is the context in which a foreign bank is
withdrawing (whether it is during a crisis or not), not the fact that it chooses to
close its doors because it is unable to make profits (which, in itself, may actually
be a desirable outcome).

Foreign bank participation, it has been shown, could lead to instability of the domestic
deposit base, especially during financial crises. Indeed, during episodes of financial turmoil,
it is common to observe a flight to quality that tends to result in a larger concentration
of deposits in foreign-owned banks

In practice, countries have very few options to prevent foreign banks from cutting lines
of credit to domestic borrowers in a crisis. Where foreign banks do not “cut and run” during
a crisis period, it has been established that they usually reduce their credits within their host-
countries.

The risk that foreign banks’ operations may lead to credit rationing to small firms
(particularly in the non tradable sector) and greater concentration in the allocation of
credit to larger and stronger ones (which are often involved in the production of
tradable) is perceived to be high. This is much unlike the domestic banks that are more
likely to be patriotic and sympathetic to the cause of the small firms, especially the
indigenous ones. If foreign banks do indeed follow a strategy of concentrating their
lending operations only to the most creditworthy corporate (and, to a lesser extent,
household) borrowers, their presence will be less likely to contribute to an overall
increase in efficiency in the banking sector, in particular, and the financial sector, in general.
More importantly, by leading to a higher degree of credit rationing to small firms, they
may have an adverse effect on output, employment, and income distribution.

Hence, theoretically speaking, an increase in the number of foreign banks in a

financial system implies a reduction in the aggregate amount of local micro-firm
financing. This could adversely affect the growth and entry of local micro firm